Lecture 6 Futures and Forwards

Learning Objectives Understand the features and roles of currency futures/forwards in foreign exchange markets Gain working knowledge of the mechanism of currency futures trading Prepare for foreign exchange exposure management Reading: Madura and Fox, Ch 5

Derivatives and Underlying Assets What is a derivative? “…is an instrument who’s value is derived from the value of an underlying asset.” The underlying asset could be the value of currency, the price of a stock, a football match result etc. Currency Derivatives: currency forwards, currency futures, currency options, and currency swaps.

How Derivatives Are Traded On exchanges such as the Chicago Mercantile Exchange, Intercontinental Exchange (ICE Europe)… Traditionally derivatives exchanges have used what is known as an “open outcry system”. Nowadays, exchanges are increasingly using “electronic trading”. Mergers between exchanges have been a recent feature LIFFE (London International Financial Futures and Options Exchange) Euronext LIFEE (Euronext acquired LIFFE in 2002) ICE Europe (ICE purchased Euronext in 2013)

How Derivatives Are Traded 2. In the over-the-counter (OTC) market where traders working for banks, fund managers and corporate treasurers contract with each other directly regarding the underlying asset, quantity, grade, location, time of delivery, price etc. On maturity the exchange must take place (different from options) Each contract is potentially unique (i.e. not standardised).

Forward Contract • A currency forward, is an “over-the-counter” (OTC) agreement between two parties to exchange currencies at pre-specified price that will be settled at a future date (i.e. to lock in an exchange rate for a short period of time.) The period is typically 1- month, 3- months, 9 and 12 –months Contrasted with a spot contract, which is an agreement to buy/sell an asset today They are not traded on a secondary market (unique contract, obligation is difficult to be sold onto a third party) • Forward contacts on foreign exchange are the most important and they are typically for very large sums ($5m).

Forward Contract • Long position and short position The party that has agreed to buy has what is termed a long position The party that has agreed to sell has what is termed a short position • Spot and forward quotes for USD/GBP as on the 24th May 2010 Bid Ask Spot 1.4407 1.4411 1-month forward 1.4408 1.4413 3-month forward 1.4410 1.4415 Forwards, being OTC contracts, don’t have market makers in the formal sense so the bid ask quotes are indicative.

Forwards (Example 1) Answer A UK company will need 1 million Singapore dollars in 90 days to buy Singapore imports. The spot rate is S0 = £0.35/S$, The forward rate F0,90 = £0.38/S$. What can the company do to avoid currency exposure? Answer a) If the firm enters long position of the forward contract with F0,90 = £0.38/S$, in 3-month time, the firm will need £380,000 (= S$1m * £0.38/S$). b) Suppose that the firm does not enter the contract, if S1 = £0.40/S$, then the firm will need £400,000 (= S$1m * £0.40/S$). hence hedging £20,000 (= £400,000 – £38,000). if S1=£0.37 /S$, then the firm will need £370,000 (= S$1m * £0.37/S$) -- forward has an extra cost of £10,000 (= £380,000 -£ 370,000 ). Though this hedging can be seen as insurance.

Forwards (Example 2 – student exercise) Suppose the UK company will need to sell 1 million Singapore dollars in 90 days from an export to Singapore . The spot rate is S0 = £0.35/S$, The forward rate is F0,90 = £0.38/S$. What can the company do to avoid currency exposure? Answer a) If the firm enters the short position of the forward contract with F0,90 = £0.38/S$, in 3-month time, the firm will receive £380,000 (= S$1m * £0.38/S$). b) Suppose that the firm does not enter the contract, if S1 = £0.40/S$, then the firm will receive £400,000 (= S$1m * £0.40/S$). lose profit £20,000 (= £400,000 – £38,000). if S1=£0.37 /S$, then the firm will receive £370,000 (= S$1m * £0.37/S$) -- forward has an extra guarantee for profit of £10,000 (= £380,000 -£ 370,000 ).

Payoffs from Forward Contracts In general the payoff from a long forward contract is: ST - Ft Where ST is the spot price of the asset at maturity T of the contract, Ft is the forward price at time t . The payoff from a short forward contract is: Ft − ST Where Ft is the forward price at time t and ST is the spot price of the asset at maturity T of the contract.

Profit from a Long Forward Position Ft = delivery price = forward price at time contract is entered into ST =Price of Underlying at Maturity Profit Ft ST 14

Profit from a Short Forward Position Ft = delivery price = forward price at time contract is entered into ST =Price of Underlying at Maturity Profit ST Ft 15

Futures Contract is an agreement between two counterparties Similar to forwards, a currency futures contract is an agreement between two counterparties to exchange a specified amount of two currency at a given date in the future at a pre-determined exchange rate. Unlike forwards, futures are standardized contracts trading on organized exchanges with daily resettlement through a clearinghouse can be bought and sold before they mature

Standardising Futures Contract However this could present a problem How do you know the other party would be able to pay? Could you easily find a contract that is in the right currencies And has the right size And matures at the right time If you have standardised contracts That are sufficiently small so that you can buy multiples to cover the exposure (but large enough so costs are not excessive) And there are enough maturity dates An active (deep) market in them can be formed.

Futures Markets Chicago Mercantile Group Three exchanges under this umbrella: NYMEX, COMEX,CBT National Stock Exchange of India Eurex Several exchanges under this company Intercontinental Exchange (ICE) Again several exchanges are owned by this company – covering many regions of the world You can see the size of markets and the trade in different types of contracts from the link on Canvas

Contract sizes of currency futures traded on Chicago Mercantile Exchange (CME) Australian dollar (A$) 100,000 Australian dollars Brazilian real (BR) 100,000 Brazilian reals British pound (£) 62,500 British pounds Canadian dollar (C$) 100,000 Canadian dollars Euro (€) 125,000 euros Japanese yen (¥) 12,500,000 Japanese yen Mexican peso (MP) 500,000 Mexican pesos New Zealand dollar (NZ$) 100,000 New Zealand dollars Norwegian kroner (NKr) 2,000,000 Norwegian kroner Russian ruble (RU) 2,500,000 Russian rubles South African rand (RA) 500,000 South African rand Swedish kronor (SKr) 2,000,000 Swedish kronor Swiss franc (SFr) 125,000 Swiss francs

Delivery Days Delivery is made on the 3rd Wednesday of the contract month (Typically in March, June, September, or December). If that day is not a business day in the countries involved, then delivery is made on the next day which is a business day in the countries.

Futures Quotes Terminology (Quotes from April 21, 2011) Settlement price: the price just before the final bell each day Unless markets are very volatile in which case the exchange chooses a settlement price used for the daily settlement process (more later) For some detailed information on how futures markets work and the details of contracts see the first page or two of: Open interest, cross listing and information shocks, Rhodes, M. Aguenaou, S  and ap Gwilym, O., Journal of Futures Markets, 2011, 31, pp755-778

Futures Quotes Terminology (Quotes from April 21, 2011) Open interest: the total number of contracts outstanding at the end of each trading day equal to number of long positions or number of short positions For some detailed information on how futures markets work and the details of contracts see the first page or two of: Open interest, cross listing and information shocks, Rhodes, M. Aguenaou, S  and ap Gwilym, O., Journal of Futures Markets, 2011, 31, pp755-778

Further aspects of futures contracts The current $US exchange rate against the £ is $1.60 / £1 And you enter a futures contract in which You agree to buy £62500 In three months time At an exchange rate of $1.70 / £1 If, after one month The $ has appreciated rather than depreciated So now the exchange rate is $1.50 / £ You will have to pay the person you contracted with But how do they know you will be able to afford this?

Futures Trading Terminology Margin and Margin Account: To begin with, the buyer or the seller of a futures contract opens a margin account with a broker. The margin is also referred to as performance bond. • Initial Margin (or Initial Performance Bond): The amount of margin per contract required to be deposited into the margin account at the time a customer places an order to buy or sell a futures contract. Maintenance Margin: A set minimum margin that a customer must maintain in the margin account.

CME customer margins $1,350 $1,000 Initial Margin Maintenance Australian Dollar (ZA) $1,350 $1,000 British Pound (ZB) $1,823 Canadian Dollar (ZC) Euro (OZ) $2,400 $1,100 Japanese Yen (ZJ) $1,755 $1,300 Swiss Franc (ZS) $1,800

Futures Trading Terminology Marking to market – deposit of daily losses/profits • Margin Call (or Performance Bond call): When adverse price movements cause the margin account to drop below the maintenance margin, the customer receives a call from the broker or the clearinghouse, to deposit more money into the margin account and bring the account back to the initial margin level. The margining system really helps avoid credit risk

Daily resettlement example – June 2011 euro currency futures Clare entered into ten euro currency futures contact traded on the CME on January 2, 2011 to sell euros in June 2011 at the price of $1.2546 for €1. or at the exchange rate of $1.2546/€. For one currency future contract, worth €125,000, the initial margin is set at $3,240 and the maintenance margin is $2,400. The daily settlement prices are given in the table on the next page. To calculate daily losses/gains, work out margin call dates and additional deposits, daily margin account balances, and the cumulative loss/gain as on January 16, 2011

Daily resettlement example – euro currency future / $US Date Settle-ment price Daily losses/ gains Cumula-tive losses/ gains Margin account balance without margin calls Margin call Margin account balance with margin calls Jan 02, 11 1.2546 $3,240.0

Daily resettlement example – June 2011 euro currency futures / $US Date Settle-ment price Daily losses/ gains Cumula-tive losses/ gains Margin account balance without margin calls Margin call Margin account balance with margin calls Jan 02, 11 1.2546 $3,240.0 Jan 05, 11 1.2621 ?

Daily resettlement example – June 2011 euro currency futures On the second trading day of January 5, 2011 the settlement price was $1.2621 /€ Clare made a daily loss: $(1.2546-1.2621) /€  €125,000 = - $937.5 per contract. Cumulative loss: - $937.5 Date Settle-ment price Daily losses/ gains Cumula-tive losses/ gains Margin account balance without margin calls Margin call Margin account balance with margin calls Jan 02, 11 1.2546 $3,240.0 Jan 05, 11 1.2621 -937.5 ?

Daily resettlement example – June 2011 euro currency futures Margin account balance without margin calls: (3,240-937.5) = $2,302.5 which was lower than the maintenance margin of $2,400, triggering a margin call to deposit more money equal to initial margin Margin call $3240-$2302.5=$937.5 per contract so the margin account balance was brought back to its initial level of $3,240. Date Settle-ment price Daily losses/ gains Cumula-tive losses/ gains Margin account balance without margin calls Margin call Margin account balance with margin calls Jan 02, 11 1.2546 $3,240.0 Jan 05, 11 1.2621 -937.5 $2,302.5 $937.5

Daily resettlement example – June 2011 euro currency futures On the second trading day of January 6, 2011 the settlement price was $1.2708 /€ Clare made a daily loss: $(1.2621-1.2708) /€  € 125,000 = $ -1087.5 per contract. Cumulative loss: - 937.5 -1087.5 = - 2025 Date Settle-ment price Daily losses/ gains Cumula-tive losses/ gains Margin account balance without margin calls Margin call Margin account balance with margin calls Jan 02, 11 1.2546 $3,240.0 Jan 05, 11 1.2621 -937.5 2,302.50 937.5 3,240.0 Jan 06, 11 1.2708 -1,087.5 -2,025.0

Daily resettlement example – June 2011 euro currency futures Margin account balance without margin calls: (3,240 – 1087.5) = $2152.5 which was lower than the maintenance margin of $2400, triggering a margin call to deposit more money equal to initial margin $1087.5 per contract into the margin account so the margin account balance was brought back to its initial level of $3240. Date Settle-ment price Daily losses/ gains Cumula-tive losses/ gains Margin account balance without margin calls Margin call Margin account balance with margin calls Jan 02, 11 1.2546 $3,240.0 Jan 05, 11 1.2621 -937.5 2,302.50 937.5 3,240.0 Jan 06, 11 1.2708 -1,087.5 -2,025.0 2,152.50 1,087.5

Daily resettlement example – June 2011 euro currency futures / $US Date Settle-ment price Daily losses/ gains Cumula-tive losses/ gains Margin account balance without margin calls Margin call Margin account balance with margin calls Jan 02, 11 1.2546 $3,240.0 Jan 05, 11 1.2621 -937.5 2,302.50 937.5 3,240.0 Jan 06, 11 1.2708 -1,087.5 -2,025.0 2,152.50 1,087.5 Jan 07, 11 1.2593 ?

Daily resettlement example – June 2011 euro currency futures / $US Date Settle-ment price Daily losses/ gains Cumula-tive losses/ gains Margin account balance without margin calls Margin call Margin account balance with margin calls Jan 02, 11 1.2546 $3,240.0 Jan 05, 11 1.2621 -937.5 2,302.50 937.5 3,240.0 Jan 06, 11 1.2708 -1,087.5 -2,025.0 2,152.50 1,087.5 Jan 07, 11 1.2593 +1,437.5 -587.5 4,677.50 4,677.5 Jan 08, 11 1.2710 -1,462.5 -2,050.0 3,215.00 3,215.0 Jan 09, 11 1.2789 -987.5 -3,037.5 2,227.50 1,012.5 Jan 12, 11 1.2700 +1,112.5 -1,925.0 4,352.50 4,352.5 Jan 13, 11 1.2699 +12.5 -1,912.5 4,365.00 4,365.0 Jan 14, 11 1.2617 +1,025.0 -887.5 5,390.00 5,390.0 Jan 15, 11 1.2529 +1,100.0 +212.5 6,490.00 6,490.0 Jan 16, 11 1.2328 +2,512.5 +2725.0 9,002.50 9,002.5

Daily resettlement example – June 2011 euro currency futures During this period, three margin calls were made An extra amount of $3,037.5 (=937.5+1087.5+1012.5) deposited per contract. Together with the initial margin requirement of $3,240, Clare put a total $6,277.5 (=3037.5+3240)per contract as deposit with her broker. The difference of the final margin account balance of $9,002.5 and the total deposit of $6,277.5, which was $2,725 (=$9,002.5-$6,277.5), was her trading gain per contract in this period. Her total trading gain in ten contracts was $27,250 (=$2,725*10).

Differences between Futures & Forwards

Conclusions Have discussed the characteristics and role of futures and forwards Understand the importance of them in international currency markets Seen how trading in them operates Briefly discussed the use of the instruments in managing foreign exchange exposure Next time will discuss options and swaps